Putting compulsion back on the agenda

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Collective membership of employers' pension schemes in the Netherlands is undesirable. That's at least the idea that is gradually taking hold in the public's mind. There seems to be a widespread belief that it restricts freedom of choice, insurance companies can provide better and cheaper pensions and that pension funds are unjustly shielded from the rigours of the free market and behave accordingly.

Laurens Blom contributes to the Dutch debate in his book ‘Compulsory pension funds discussed', reviewed in the IPE May issue by Cyril Widdershoven. Blom argues that pension funds overstate their returns and questions the value and necessity of compulsory, collective pension schemes in the Netherlands.

We support Blom's initiative in reopening the public debate on this issue. Compulsory saving in a collective scheme forms the foundation on which the success of the Dutch pension system has been built, but we should not take it for granted. Compulsion is, after all, inconsistent with the zeitgeist which favours greater scope for market forces, lower costs and, above all, more individual choice. Saving for your pension via your employer's compulsory group pension scheme does not fit well with this market philosophy.

These are the arguments, in a nutshell, propounded by the nay-sayers in the debate on the desirability of compulsory membership. However, the case put forward by Blom's study fails totally to address either the interests of the members or the part played by compulsion in the Dutch pension system. Contrary to what the book's title suggests, the author touches hardly at all on the social role of compulsory pension fund membership.

Reducing compulsion to just the return on investment is a too narrow view. Study after study shows that most of us are short-sighted when it comes to making provision for our old age. We save too little and too late. There are several unfortunate examples one can cite. In the UK in the early 1980s, Prime Minister Thatcher forced the move away from group pension schemes towards individual pension plans. Twenty years on, hundreds of thousands of UK households are facing a life of poverty because their pensions turned out to be smaller than they had expected - and would have received if they had continued saving compulsorily for their pensions. The problems have now grown to such a magnitude that the Blair administration doesn't know where to start sorting out the mess.

The position in the US is not very different. Most American employees save voluntarily via individual (401K) pension plans, and two-thirds are saving too little to secure the pension income they envisage.

Not only do we not save enough, we can't even be bothered to give the matter serious thought. A study by Henriëtte Prast in 2004, for example, revealed that Dutch members had little interest in greater individual choice in their pension scheme. So there is something to be said for compulsion. Slightly paternalistic, but with the best intentions and with the best possible outcome for members.

A pension fund also provides solidarity: everyone with a contract of employment automatically becomes a member of the pension scheme. In the Netherlands, opting out is not an issues. Compulsion simply means that everyone saves for his or her retirement, from the lower-income groups to the top earners. It is the lower-income groups in particular who need a push to make sure they save enough.

The fact that so many people participate creates all kinds of scale and scope economies, not captured by market forces. Risk (longevity risk) can be hedged more effectively and at a lower risk premium on a collective basis and across generations. The best way of funding the ageing of the population is still to accumulate collective buffers and pass these on to future generations. These provisions are essential at a time when more and more costs are being transferred to the individual, who can no longer see the wood for the trees.

Compulsion is in the members' best interests. Blom focuses only on the returns which pension funds earn - not that a critical review of this aspect of their performance is unwelcome; PGGM came out on top.

Recalculating published, audited returns, he concludes that only a few pension funds face up to the test, mainly by switched into equities in time: Shell, Unilever and PGGM.

He takes the view that the other funds missed out on the equity risk premium and might just as well have stayed in bonds. He bases this conclusion on the method used to recalculate the return.

In our view, here he completely misses the point and undermines his own research. He argues that the investment return for pension funds should be calculated using a different method from that applied by commercial pension providers, such as insurance companies, because pension funds perform a social function. Using this different method, the pension fund returns seem lower.He further argues that pension funds switched into equities too late and that this strategic decision was mistaken. We should like to correct this misconception. Pension funds do indeed perform a social function: the members are the principal stakeholders and all investment earnings flow to them. For insurance companies, the most important stakeholders are the shareholders.

The same method of calculating the return can, however, be used for both insurance companies and pension funds. In the case of the former, the calculation is performed on an individual basis: how much do I have in my individual account at the end of the year? In the case of a pension fund, it is performed on a collective basis: how much are the assets worth at the end of the year?

In their regulatory capacities, both DNB and AFM have been emphasising the similarities between financial institutions rather than the differences in recent years. Sadly, Blom fails to explain adequately why he is swimming against the tide. PGGM has achieved an average annual return of 9.2% since 1970 and 10.1% over the past decade, which includes the lean years of 2001-2003. PGGM's strategic decision in 1995 to invest almost half the pension assets in equities was evidently the right one.

Even assuming that commercial pension providers could match these outstanding results (adjusted for the chosen asset mix), the returns will still differ significantly owing to the difference in costs.

Pension funds do not incur marketing expenses, have no branch networks and are non-profit, so their costs are very low. The difference can easily amount to one percentage point per year.

At the end of the member's working life, a pension fund can therefore build up 40% more capital, a substantial economic net gain to society which, in the case of a pension fund, is passed on in full in the form of lower contribution rates or enhanced pension rights. No calculation method can alter these facts.

We welcome Blom's initiative in putting compulsion back on the agenda, but we should prefer the debate on the differences in returns between pension funds and commercial pension providers to be based on the same assumptions.

More important, however, is a balanced assessment of the advantages and disadvantages of compulsion, both for the members and for the Dutch pension system. We should, at least, like to see included in that agenda a discussion of how compulsion can help safeguard the future of our pension system and which approach offers the best solution to funding the ageing of the population.

Our system of compulsory pension fund membership is widely admired in other countries and the Netherlands is renowned for its high participation rate. Are there good practices we can adapt from other countries or - perhaps even better - export to them?

Rene van de Kieft is chief financial officer of PGGM. Alfred Slager is Assistant Professor of Finance at the RSM Erasmus University, the Netherlands. He is also project manager at PGGM Investments